Welcome to purgatory

You knew it had to happen eventually. After avoiding the worst of the credit crisis, middle–market deals, which we define as falling between $100 million and $1 billion in total deal value, have clearly been affected by the deepening slowdown in the economy and the loan markets. Even the most optimistic middle–market dealmaker admits that the contagion has spread. Gone is the idea, widespread as recently as this summer, that middle markets would escape the worst effects of the broader M&A slowdown due to their smaller size, dearth of leverage and predominance of equity–heavy deals. The meltdown on Wall Street that took out Bear Stearns Cos., Lehman Brothers Holdings Inc., Merrill Lynch & Co. and others has trickled down to even the lower–middle markets and across virtually all industries. What’s still open for debate is just how bad things are going to get.

“I think we’re kind of in purgatory,” says Douglas J. Dossey, a managing director at FdG Associates LLC in New York. “Things can get worse in debt markets. Things can get worse in the economy. Not that things haven’t trickled down, there’s just so much uncertainty.”

Howard Lanser, director of mergers and acquisitions and investment banking at Robert W. Baird & Co., views this uncertainty as “the biggest danger right now, because people can’t wrap their arms around what’s happening.” Lanser senses dealmakers are waiting for the other shoe to drop but that “they’re not sure which shoe it is. We’re in an environment now that we’ve never experienced before, and people are trying to lasso how to price risk,” he says.

Credit spreads have predictably blown up as a result. “The spread we’re looking for over LIBOR –– not just us but the entire middle market –– has moved from LIBOR plus 300 basis points to probably north of LIBOR plus 500 basis points,” says Gregg Smith, group head of CIT Investment Banking Services. This doesn’t take into consideration that LIBOR itself has moved up by around 100 basis points since Sept. 15, the day Lehman declared bankruptcy.

“We’ve got deals in the market right now –– not just we but the entire marketplace –– that are pausing,” Smith says. “We’re trying to figure out where they’re going to go in terms of pricing and structure, and then we have deals that folks were getting ready to launch that are certainly stopping.”

This lack of clarity vis–?–vis risk –– Lanser calls it “the greatest enemy of credit markets right now” –– is making deal financing extremely difficult, to put it mildly. But it’s not the only factor dragging down deal activity. The amount of equity required to get a middle–market transaction done has nearly doubled over the past year, say dealmakers. “Twelve to 15 months ago we were seeing a lot of deals get done with 20% equity,” Smith recalls. “Right now, you’re starting at 35% equity, and a lot of it’s even more than that. You need a lot more equity to get a deal done, and then the pricing is blown out.”

Brian Keane of Citi Global Wealth Management cites similar numbers. Equity is now in the 30%–40% range versus a 20%–30% range in prior years, he figures.

The time to close has also been extended as a result. “Buyers in general are cautious, in terms of execution, that they’re getting what they thought they’re getting,” says John Sinnenberg, managing partner with Key Principal Partners LLC, where he manages the direct investment team and also oversees a $1 billion fund–of–private–equity–funds, 65% of which is invested in middle–market buyout strategies. From 2004 to 2006, the average close time was six to eight weeks, according to Sinnenberg. Now it’s eight to 12 weeks, he says.

The problems facing middle markets are firmly rooted in the malaise that has decimated Wall Street. Investors who typically support financial institutions have grown tired of the lack of transparency in terms of the underlying assets, Sinnenberg says. For several quarters now, investors have been hearing CEOs and management teams say their problems are behind them, only for the same issues to arise again in the next reporting cycle. Ultimately, these institutions are left short of cash and have to go hat in hand to investors and public markets –– with limited results for all but the very largest. “Right now these firms are really having trouble raising outside capital,” Sinnenberg says. “Even when the ones with good ratings go to leverage capital, that market is so expensive it’s not particularly attractive to lend to businesses. So even though spreads for businesses have gone up, the margin they demand off of businesses –– the banks’ cost of funding –– has also gone up. Banks are paying 150–250 or more basis points to lever their capital, so there isn’t a great deal of economic incentive to lend out money. Once you get beyond the deposit base, it’s really hard to get returns in the commercial market. You really can’t be sure your funding costs are going to be in place to profit on the loan –– or even to fund the loan.”

“We’ve had conversations with clients, and the issue of liquidity is talked about a lot from a bank’s perspective,” adds Paul Schneir, co–head of the M&A division at KeyBanc Capital Markets Inc. “Even when [companies] have access to cash, there is a concern: ‘Will the cash be there? Will the banks be there when I really need them?'”

To circumvent these concerns, companies have taken to prefunding debt. Schneir recalls a client who announced a deal in the $200 million to $300 million range and “basically prefunded the debt weeks before the closing. Their view was ‘We’re not sure the banks are always going to be there. We want to be sure we can close the transaction.’ ”

On top of everything else, buy–siders are decrying a lack of attractive companies coming to auction. “There’s a shortage of a supply of deals,” says Markus Lahrkamp at Arthur D. Little’s private equity advisory group. Lahrkamp understands the reluctance of business owners to seek an exit in these times. “If I was an owner and did $75 million [in sales] and was doing well, why would I sell right now?” he asks rhetorically. “I might as well ride it out.”

This makes private equity groups, the traditional saviors of business in bad times, reluctant to put their cash to use. “We’re not seeing a lot of searches or market screens for opportunities,” Lahrkamp says. Besides the lack of attractive targets, concerns over exit opportunities, in part driven by frozen credit markets, are keeping many on the sidelines. “If you have to exit, if you need to close your fund or you need to get returns and get out of a business, it’s going to be difficult,” Lahrkamp says.

Add it all up –– hamstrung lenders, uninterested (or worse) investors, large–scale uncertainty –– and it makes for a very ugly environment. Toss in traumatized markets and partisan bickering, and you have what Lahrkamp describes as “a perfect storm facing the market.”

Which begs the question: Are there bright spots? And how much longer will purgatory last?

First the bright spots:

The lower–middle market, while still affected, has not been completely devastated. “Compared to the big PE, the middle market still holds up OK,” Lahrkamp says. That’s because of the specific functions served by middle–market private equity: “not only capital but operational support that makes sense and explains why they are doing relatively OK.”

A few middle–market firms insist business is holding up or even improving. “We are having a great year despite the market and have a reasonable chance to meet 2007 levels of both deal closings and revenue,” says Giles Tucker of Harris Williams & Co. Tucker says his firm closed 12 transactions in July and August alone, worth $2.7 billion or $2.8 billion in total value. “The buyers for those transactions continue to be a good mix of strategic and financial buyers,” he adds. Good assets with good management teams in companies with strong market positions are still being pursued, says Tucker, who adds that he hasn’t seen reductions in valuations.

Chip Grayson Jr. of Morgan Keegan & Co. does see multiples trending downward, but not out of the range where deals become imperiled. “Where we were selling a company at 8 times in 2007, today it is 7.25 times, although we are trying to manage sellers’ expectations down to where we think buyers are,” he says.

Sinnenberg agrees that the low end of the middle market could escape some of the worst damage, mainly because this sector was nowhere near as highly leveraged as the upper end. “Those businesses should not have as much difficulty,” he says, sounding a degree of caution. “The smaller the business, the less resistant it is to downturns in the economy. If we get a meaningful recession, those small companies, as unlevered as they are, are going to feel it more. They typically don’t have as much international exposure and are more reliant on domestic companies.”

Additionally, lenders are sure to punish defaults even more severely than they would with bulge–bracket firms. “As soon as you hit a default, your spread is going up 200 to 300 basis points. When you get that kind of change in a downturn, you’re just accelerating the degree of difficulty the company has to fight.”

Instead, Sinnenberg anticipates that noncontrol investing will become a trend in private equity –– something he has already witnessed at his own firm. “For our noncontrol business, we’ve already started to see an uptick in dealflow because companies that need senior debt will go for some form of noncontrol junior capital,” he says. “We’re starting to see a lot of opportunities to provide subdebt at senior debt risk with distressed returns, which is a pretty good trade.”

As for how long the current uncertainty will last, CIT Investment’s Smith expects a delay of six to nine months before lenders re–enter the space. “The events of the last couple of weeks are causing even the middle markets to pause,” he says. “So players who were looking to come into the market are having a hard time getting in. Folks that had been lending aggressively into the market are taking a little bit of a breath, [as are] the large regionals and the universals that we expected to come back into the market.”

Sinnenberg says two full quarters of reasonable stability in the financial markets are required. “Then investors may have faith these guys [investment banks] actually know what’s in their portfolio.”

For Lanser, it’s simply too soon to tell. But check back with him next month. “The way the credit market goes for October is the way M&A will go for the next year,” he says. While Baird has not seen any of its deals halted, he says, “clients are obviously worried. … Deals in our pipeline are supposed to close in October. Once we get some certainty, the credit markets will stabilize one way or another: stabilize and get better or stabilize and make dealmaking next to impossible.”

“The events of the last couple of weeks are going to cause a great deal of stress in middle–market dealflow,” Smith says. “The fallout is going to be fairly traumatic over the next three months, which doesn’t mean it’s going to stop forever. It just means the next three months are going to be pretty tough for all of us.”

About Key Principal Partners

Key Principal Partners (KPP) is a $1 billion private investment firm that provides expansion capital to profitable middle-market companies with at least $30 million in revenue. The firm has the flexibility to provide any combination of subordinated debt, preferred equity and/or common equity in either non-control (minority ownership) or control (majority ownership) positions. KPP can invest between $10 million and $40 million to facilitate the growth, acquisition, refinancing, deleveraging or liquidity needs of private company owners and their management teams. Affiliated with KeyCorp, KPP is headquartered in Cleveland, and has additional offices in Greenwich, and San Francisco.

About KeyCorp

Cleveland–based KeyCorp is one of the nation’s largest bank–based financial services companies, with assets of approximately $97 billion. Key companies provide investment management, retail and commercial banking, consumer finance, and investment banking products and services to individuals and companies throughout the United States and, for certain businesses, internationally. For more information, visit www.Key.com.